Chapter 4 (cont’d)
Applications: ELASTICITY AND REVENUES
• Many businesses want to know whether
raising prices will raise or lower revenues.
• In other words, businesses must decide
whether it is worthwhile to raise prices and
whether the higher prices will make it up for
the lower demand.
• To answer this question, the relationship
between price elasticity and total revenue
must be examined.
• 𝑇𝑅 = 𝑃 ∗ 𝑄
• What will happen to total revenue when price
increases?
• To answer this question, you need to know the
price elasticity of demand. Three cases:
– When demand is price-inelastic, a price increase
raises total revenue.
– When demand is price-elastic, a price increase
decreases total revenue.
– In the borderline case of unit-elastic demand, a
price increase leads to no change in total revenue.
• What about a price reduction?
Other Important Elasticities
1. Income Elasticity of Demand
• Income elasticity of demand A measure of the
responsiveness of demand to changes in income.
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝐷
• 𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒
– Case of Normal Goods:
𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 is positive
– Case of Inferior Goods:
𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 is negative
2. Cross-Price Elasticity of Demand
• cross-price elasticity of demand A measure of the response
of the quantity of one good demanded to a change in the
price of another good.
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝐷 𝑜𝑓 𝑌
• Cross−Price 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 = % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑋
• Case of Substitutes:
– 𝐶𝑟𝑜𝑠𝑠 − 𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 is positive
• Case of Complements:
– 𝐶𝑟𝑜𝑠𝑠 − 𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 is negative
3. PRICE ELASTICITY OF SUPPLY
• Of course, demand is not the only thing that
changes when prices go up or down.
• Businesses also respond to price changes in
their decisions about how much to produce.
• The price elasticity of supply is the
percentage change in quantity supplied
divided by the percentage change in price.
Polar Cases:
1. Completely Inelastic supply:
• Suppose the amount supplied is completely
fixed, as in the case of fresh fish brought to
the market to be sold at whatever price.
• This is the limiting case of zero elasticity,
which is a vertical supply curve.
2. Infinitely Elastic supply
• At the other extreme, say that a tiny cut in
price will cause the amount supplied to fall to
zero, while the slightest rise in price will
induce an indefinitely large supply.
• Here, the ratio of the percentage change in
quantity supplied to percentage change in
price is extremely large
• Gives rise to a horizontal supply curve.
• Between these extremes, we call supply
elastic or inelastic depending upon whether
the percentage change in quantity supplied is
larger or smaller than the percentage change
in price.
• Note that the definitions of price elasticities of
supply are exactly the same as those for price
elasticities of demand. The only difference is
that for supply the quantity response to price
is positive, while for demand the response is
negative.
Factors determining supply elasticity:
1. Ease with which production in the industry can
be increased.
– If all inputs can be readily found and employed at
going market prices, as is the case for the textile
industry, then output can be greatly increased with
little increase in price.
• This would indicate that supply elasticity is relatively large.
– On the other hand, if production capacity is severely
limited, as is the case for gold mining, then even sharp
increases in the price of gold will result in a small
response in gold production;
• This would be inelastic supply.
2. Time period under consideration
– For very short periods after a price increase, firms
may be unable to increase their inputs of labor,
materials, and capital, so supply may be very price
inelastic.
– However, as time passes and businesses can hire
more labor, build new factories, and expand
capacity, supply elasticities will become larger.
APPLICATIONS TO MAJOR ECONOMIC ISSUES
• We will now show how the previous tools
(supply, demand and their elasticities) can
assist our understanding of policy issues.
• We will start with examining the implications
of a new tax.
• Then, we will analyze the consequences of
various types of government intervention in
markets.
1. IMPACT OF A TAX ON PRICE AND QUANTITY
• Governments tax a wide variety of
commodities—cigarettes, gasoline, imported
goods, telephone services, and so on.
• We are often interested in determining who
actually bears the burden of the tax
– Here is where supply, demand, and their
elasticities are essential.
Example: A Gasoline Tax
• Suppose that some members of parliament
suggest raising gasoline taxes by $2 per gallon.
– What would be the impact of such a change?
• Prudent legislators would be reluctant to raise
gasoline taxes without knowing the
consequences of such a move.
– …the incidence of the tax.
– By incidence we mean the ultimate economic effect of
a tax on the real incomes of producers and consumers.
• Using supply, demand and their elasticities, we
can analyze the exact incidence of the tax.
The key issue in determining tax incidence
The relative elasticities of supply and demand.
– If demand is more inelastic relative to supply, as in
the case of the gasoline example, most of the cost
is shifted to consumers (they bear $1.8 out of the
$2 tax, whereas the producer bears $0.2 only).
– By contrast, if supply is more inelastic relative to
demand, then most of the tax burden will be
shifted to the suppliers.
